Wednesday, February 06, 2013

On the iatrogenic explanation of post-recession stagnations

I think that title really reaches out of the screen and grabs the reader, don't you? :-)

Anyway. John Cochrane has been diligently working through New Keynesian macro models, and in this post he evaluates their ability to explain the long post-recession stagnation we've been experiencing, as well as their policy prescriptions. Some excerpts:

The level of today's consumption depends on the whole string of future interest rates, not just today's interest rate. So, if people expect the interest rate in 2014 to be lower, that is every bit as effective in raising today's consumption as would be lowering today's rate.

Hence, "open mouth operations," "forward guidance," and "managing expectations." If the Fed by just talking can persuade people it will hold interest rates low for a longer periods, when they are expecting rates to rise above zero, that expectation will "stimulate" today's consumption. If promises don't help, perhaps announcing a new "rule" which if followed would lead to lower rates for longer will help to change expectations.

In this equation, more inflation lowers the real interest rate too. So, anything that boosts inflation is a good thing. Boosting inflation isn't primarily about a Phillips curve, direct "monetary stimulus," encouraging investment, and so on. It's a way to lower real interest rates inside the integral and shift consumption from the future to the present.

Once again, increasing expected future inflation would be just as effective as increasing current inflation. Hence, calls for the Fed to announce a higher inflation target, or at least announce that it will tolerate more inflation before beginning to raise rates, as it has.

He points out what he sees as some of the limitations of this story:

New Keynesian models are a bit fuzzy on just why...the "natural rate" is sharply negative...Many of the formal models assume that consumer's discount rate (rho) has declined sharply, beyond the capacity of the interest rate to follow it...

Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy...

To be fair, all the papers I've read say clearly that they regard the decline in the discount rate rho as a stand-in for some more complex process involving the financial crisis...

New-Keynesian introductions have something more complex in mind, involving the "frictions" of the financial crisis...But that too is really not our question. The "frictions" of the financial crisis -- capital constraints at banks and financial intermediaries, or the run in the shadow banking system -- passed quite a while ago...

The question before us is not really why consumption fell so drastically in 2008 and 2009. The question is, why did consumption get stuck at so low a level starting in 2010?...

This question and controversy is much like those surrounding the Great Depression...[W]hy did the US get stuck so low for so long? Was it bad monetary policy (Friedman and Schwartz), bad microeconomic policy, war on capital, and high marginal tax rates (Cole, Ohanian, Prescott, etc.), or inadequate fiscal stimulus (Keynesians)?...

I guess you could argue for a constant sequence of unexpected negative shocks, so that each quarter, people are expecting the big consumption growth which just ends up not happening. But you can see how strained that argument is. It would be much more appealing to refer to a model and analysis that describes slumponomics directly.

I think Cochrane is being a little too dismissive of the "string of negative shocks" idea. My suspicion is that a global financial crises can circle the world like a tsunami, rippling out from America and triggering crises in Europe, Japan, and China that then impact the U.S. a few years later.

But I agree that New Keynesian models are very stylized and opaque. It's easy to solve them, but not at all easy to tell what real-world economic forces correspond to the thing you're solving. New Keynesian models basically sacrifice realism for tractability, a sacrifice imposed on them - it seems to me - by the need to follow the kludgey DSGE modeling format. For example, we know that prices don't get set by Calvo pricing, and yet many New Keynesian models have this feature.

Anyway, Cochrane prefers a different explanation for the long post-crisis stagnation: an iatrogenic one. "Iatrogenic" is a medical term for when an attempt at treating a person causes even greater harm (such as when a routine operation paralyzes a patient). Cochrane supports the idea that government policies that arose in response to what would otherwise have been a short, sharp crash in 2009 ended up making things far worse by causing a long drawn-out stagnation. However, he admits some problems with this view as well:

Like the new-Keynesians, I won't be that specific here about just why consumption fell so drastically in the financial crisis...From [my] perspective, consumers realized in fall 2008, that this recession was going to last forever rather than bounce back quickly, and they adjusted consumption downward accordingly. They were right. Just how they knew, when all the Government's forecasters thought we would quickly bounce back, is an interesting question. Surely, my litany of free-marketer's complaints did not obvioulsy get suddenly worse in October 2008, just coincident with a run in the shadow banking system. Well, maybe not so surely. Maybe consumers thought, we're in a horrible banking crisis, and our government is likely to prolong this one with ham-handed policies just like they did in the 1930s. But that's pretty speculative. And I do think (just as speculatively) there was a run in the shadow banking system, effective risk aversion spiked, and the financial crisis was more than just a signal of bad policy to come.

But all that is a topic for another day...

Actually, I think there are two other big problems with the "iatrogenic" explanation of our stagnation.

First, and most importantly, there's the international aspect of the economy. Here's Cochrane's picture of how American consumption has "downshifted" since 2008:

A graph of GDP will look the same. But look at any rich country, and chances are that it experienced the same kind of "permanent downshift" in its consumption after 2008! European countries. Japan. Or look at the graphs for other countries that experienced financial crises - Japan and Sweden after 1990. Korea after 1997. And so on. They all look pretty much the same - a long trend, followed by an abrupt fall, followed by a resumption of growth at the previous trend but at a lower level. Here are two from Sweden and Korea:

Looks familiar, right?

How plausible is it that expectations of future government policy (and government policy itself) would react in exactly the same way all around the world? It does not seem very plausible to me, given the huge heterogeneity of governments and policies.

My second problem with the "iatrogenic" model is prices. Although (as Cochrane points out) the lack of deflation since 2009 is a problem for some New Keynesian models, the lack of inflation seems to me to be a problem for the kind of "permanent income" model that Cochrane prefers. In a simple Econ 102-type AD-AS model, if you have a negative shock to long-run supply (permanent income), prices have to rise rapidly at some point. The logic is simple: An impairment in productive capacity should cause shortages. But since the financial crisis, U.S. inflation has been very subdued:

Now, I realize that AD-AS logic is pretty simple. But I also know that it's very tricky and difficult to get macro models to tell you that a permanent supply shock has an impulse response on prices that never pokes its head above zero. You can do it, but it's my understanding that you need to use things like "news shocks" and other such assumptions about the timing of information arrival. It ends up looking pretty weird.

So I think that while there are definitely problems with the New Keynesian interpretation of the world, there are even more problems with the idea that government policy (and far-sighted citizens who guessed government policy years in advance) caused our long post-crisis stagnation. My intuition says the most likely explanation - unfortunately - is that there are some very deep things about how economies work that no macro model yet encompasses.

87 comments:

But, i wish people (him, you, whoever) would take door #3 (Old Keynsianism) more seriously. Once we throw out the idea that there is a true expected lifetime income, and accept that economic units make decisions about current expenditure based on current income, a lot of what happens in the economy makes much more sense.

Old Keynesianism gives a prescription for ending our current post-crisis stagnation, but it doesn't really give a satisfying answer to the question of what is causing the stagnation in the first place.

Well it does but Keynes and his contemporaries decided not to put them in the models. The answers are in the realm of "animal spirits", "liquidity trap", "paradox of thrift", "nominal wages don't fall" etc. etc. Seems pretty satisfying compared to "recessions might me caused by a negative technology shock and change of preferences". Why have a higher standard for Keynesian economics than the trendy stuff?

BTW, AS-AD, IS-LM etc. are comparative statics models after all. Don't they imply that that for example a shift in the IS curve to the right will cause a recession and the economy will stay there? Outside of the business cycle events your only movements of the curves are policy actions (which I guess makes it a "chicken-model", according to Lucas).

tl;dr I mean IS-LM and the consumption function aren't the full Old-Keynesian model.

I believe that the usual story about what caused the stagnant economy is that the bursting of the housing bubble led to the evaporation of imaginary wealth so that people are now poorer, spend less, and want to deleverage.

But they (both shocks) have had sizes and spreads absolutely different.If one wanted to portray the would-be effects of such a shock in the consumption pattern, the picture would not be that different of the ones Noah bring us in the post.The question that "no macro model yet encompasses" is the consistency between flows and stocks.And there is another aspect that no short-term macro model will encompass: Is it possible to guarantee a 3 % rate of growth for consumption without some financial trick? if the answer is NO, one could probably figure out that the apparent level effect ought to be in fact the transition to a different long term path.

But I still don't see what isn't satisfying about the paradox of thrift for example. Maybe a DSGE that achieves everything will be OK? As far as I know there are people in Princeton who have done it already.

Well, the people who have modeled the Paradox of Thrift have done it in a New Keynesian context, which (as Cochrane shows) definitely has some differences from the "old Keynesian" models used in the past.

Naturally the huge collapse in wealth due to the housing crash, plus continued high unemployment and the worries about losing your job and not being able to get another would have nothing whatsoever to do with consumer confidence. No, they're all just sitting in their about to be foreclosed houses glued to the news to see what the Fed has to say. Yeah, that's it.

I don't agree with him (Cochrane), but do you need to assume that each country would make its own separate policy mistakes? If we assumed that the US alone had made a policy mistake, then I would think that that would be enough to explain reduced demand right across the globe. Seem to recall somebody making the argument that the inter-dependency of GDP between countries runs much deeper than you would expect if you just looked at global trade relative to global GDP, and the US is traditionally seen as the demand engine of the global economy.

I like to explain the preference shocks as representing non-market interactions between people. In a typical model where the preferences are non-stochastic, all interactions between individuals are coordinated by the price system. But in reality that need not be the case--individuals can interact with each other on a personal level without prices, which happens, for example, when an employer tells people that he may have to lay off workers in the future due to the economy. This non-market coordination of activities can be represented in the aggregate by a shock to preferences. Moreover, this possibly could be the only way to represent such interactions in an economic model (though, we should allow for the possibility that preference shocks are endogenous).

You should be mindful that people are laid off all the time and need to find new jobs. If the unemployment rate is high, then finding a new job will be difficult. So, even if there is no increase in the likelihood of layoffs, higher unemploymente will tend to raise saving by those employed.

The assumption that people must fear losing their own jobs is an assumption that "normally" layoffs are zero. We don't live in that kind of economy.

New Keynesian models basically sacrifice realism for tractability, a sacrifice imposed on them - it seems to me - by the need to follow the kludgey DSGE modeling format.

It seems to me that the sacrifice is imposed by economists reluctance to let go of their algebra and calculus skills. Other fields stopped using such simple models for any real world problem a long time ago. Climate models are not solvable. Neither are protein folding models, aircraft aerodynamic models or molecular interaction models. Not even the three body problem is (usefully) solvable!I really hope that simulations (ABM in particular) gain more acceptance in the mainstream, so that simplifications of which the impact is unknown are not used.

So one should use models that are not solvable? Wow, that's a revolutionary methodological insight :)

Of course, all the models you mention are solvable by approximate numerical methods. Modern macroeconomic models almost always don't have analytic solutions and thus must also be solved numerically. They are often evaluated or estimated using simulations too. Looks like economists have overcome their "reluctance to let go of algebra and calculus skills" long time ago.

The key difference is that DSGE models incorporate individual optimization, forward-looking behavior and rational expectations, so that "solving" them typically means solving functional equations, which is hard and places limits on size of the models. On the other hand, ABM models skip this problem by specifying behavioral functions directly, so that even large model can be easily simulated. They replace one unrealistic limitation for another - which of course may make sense in particular situations, but it's not a silver bullet.

"forward-looking behavior and rational expectations, so that "solving" them typically means solving functional equations, which is hard and places limits on size of the models."

If you look at open contests like Netflix you find guys solving problems involving tens or hundreds of millions of variables on desktop computers. I spent some time doing numerical analysis a long time ago. I can't help but think that if the economists can't solve their problems they need to go talk to some good numerical analysis people.

Machine learning is about a different class of problems. And there are people in economics who do pay attention to numerical analysis (like Kenneth Judd). But there is simply this thing called curse of dimensionality. For example, if DSGE models were formulated in continuous time, one would have to solve partial differential equations to obtain consumption function, etc. (with discrete time, one obtains functional/integral equations, but the point is similar). Number of "space" dimensions would be equal to number of state variables, of which a medium-scale DSGE model would have several, maybe even a dozen. Solving PDEs in 10 dimensions is surely a nontrivial problem, even for modern numerical analysis. Thus we have to resort to further approximations, like linearizing the model around steady state.

Any model that requires knowledge of the future (as opposed to predictions about the future based on the current or the past) is WRONG.

If the states are expressed as probability distributions then it seems to me that each variable could be accurately represented at each point in time by 10,000 unknowns (and probably fewer). If we take 100 state variables, a one week time step and a twenty year time period we have 100 x 10,000 x 1000 = 10^9 unknowns but the matrix representation will be banded (the band might be O(10^6) wide but that is a lot better than 10^9). Such a model should be computationally tractable on computer systems readily available on college campuses.

I had a quick look for some of the discussion by economists on numerical solutions - the current work seemed to be where the numerical analysts were thirty five years ago.

Let me put it another way: The underlying problem is not intractably large (there are only so many people in the world and they fall into clusters). If your model is intractably large then there is something wrong with your model.

The problem with numerical models is that you do not get insights, like you do with analytical solutions. In most cases, you have no idea what is driving your results. The question is whether you gain something from this loss of understanding.

@ivansml: ABM can also incorporate individual optimization, forward looking behavior and rational expectations. The difference is that DSGE modeling means actually solving the equation system, while ABM doesn't. Solving a 10 dimension PDE system is indeed nontrivial, nobody disputes that. But an economy has much more than 10 dimensions, so simplifying to 10 might mean your model doesn't capture the real world well enough. Getting relieved of the necessity of solving a nontrivial equation system sounds like a win to me.

@Absalon: I guess this is getting bit off-topic, but your system would be typically nonlinear. I don't think solving nonlinear systems with millions of variables is feasible unless you can exploit structure of the problem in some way. Also, you are underestimating effects of uncertainty - for example, if only source of randomness is simple 2-state Markov chain (e.g. productivity can be high or low), choice in each period may in principle depend on whole history of productivity realizations up to that point, so you need 2^t nodes in period t, which rises fast. That's why it's usually preferable to formulate the problem in recursive form.

Although there can definitely exist opportunities for using better numerical methods in economics, if there was any obvious "free lunch", somebody smart would have already figured it out.

@felipe: OK, ABMs can include approximations to those concepts, like people switching their strategies or predictors depending on their historical performance, but that's not quite the same thing. At the very least, you still need to specify parametric forms (and parameter values) of strategies, learning process, etc., while most of these would be endogenous in DSGE model. As I said, the tradeoff may be worth it in some situations, but in the end, ABM approach will be successful when it delivers better insights than alternative models. Has that happened so far?

It is generally easier to solve non-linear problems numerically than it is to solve them analytically. Millions of unknowns does not make a non-linear problem unsolvable - as witness the widespread use of SVD based methods in the Netflix prize.

A model which you cannot "solve" in some sense is useless. A linearization of a model around a steady state (or around a status quo) is a different model.

In numerical analysis the difference between a simplistic (albeit correct) method and a more sophisticated method for solving a problem can be multiple orders of magnitude in run time (think bubble sort vs. merge sort).

The problem with numerical models is that you do not get insights, like you do with analytical solutions. In most cases, you have no idea what is driving your results. The question is whether you gain something from this loss of understanding.

You can get insight from such a model; sometimes more easily than from a closed form equation. You can discover emergent phenomena that would not be apparent from looking at equations. You can determine what's driving your results by turning on and off or otherwise varying pieces of the model and seeing their effects. You work empirically, performing all the experiments on your model economy you wish you could perform on the global economy and see what happens.

The problem with analytical solutions is that to insist on one is to assume a whole lot about how the economy works that you don't necessarily intend to assume. For example an model economy with a closed form solution will not exhibit butterfly effects. The whole approach makes the non-existence of endogenous shocks a foregone conclusion, even though very simple models following plausible rules exhibit them; shouldn't we want an approach that can tell us what makes them more or less likely or worse when they happen?

The tough thing is expectations, but you can give agents diverse expectations and to whatever extent the economy rewards agents with correct expectation over time the model economy should behave more rationally over time. Assuming individual investors to have perfect foresight is much less realistic anyway.

This is not really a comment, but a question, if anyone knows the answer: where does debt overhang enter into these models? This issue doesn't seem to be discussed anywhere in the above, unless it is somehow assumed to be embedded somewhere. Isn't debt still pretty large out there, for corporations, people and governments? Might not this have something to do with the slow growth? Or is this just a silly idea?

This is not silly at all, and in fact is one of the things I was alluding to at the end. No one knows why debt deleveraging happens. Why do people who were content taking on more and more debt suddenly decide "OK, now is the time to pay off a bunch of my debt"? Why does this behavioral change last a long time? When does it stop? When do companies expect it to stop? These questions need to be answered before we can have a predictive model of deleveraging. But yes, that's one of the major things I'm thinking of when I talk about phenomena not encompassed by current macro models.

I'd say it's an active research area. Models with financial frictions (Bernanke-Gertler, Kiyotaki-Moore,...) place constraints on leverage of enterpreneurs, and if those constraints change, you will get deleveraging which will have effect on real economy. On household side, deleveraging was studied e.g. in Eggertson and Krugman paper (which has some references to other research, and has accumulated quite a few citations itself).

But yeah, typically the change in leverage is caused by exogenous shock, or as a response to other exogenous shocks. Surely there are people who study microfoundations for endogenous leverage, but it may take some time until we have a satisfying integrated theory (and by then another crisis will come, caused by something entirely different).

For most individuals and corporations debt is simply part of their calculation of their wealth (net equity). If they have a lot of debt and want to increase their net wealth, they may choose to pay down the debt.

"My intuition says the most likely explanation - unfortunately - is that there are some very deep things about how economies work that no macro model yet encompasses."

Though you are right that there is no complete model, I don't think it's that* deep.

First, credit spreads exploded in an extremely sudden way. If you want to maintain lending rates at a constant level, you'd have to cut the risk-free rate dramatically. I.e. the natural rate *plunged*, way below -2%. Presto, liquidity trap!

And if you want to know *why* credit spreads exploded, well that's not very complicated either: there was a housing bubble facilitated by derivatives (embedded in structured products) which connected deadbeat borrowers with those least capable of evaluating the risk. Government approved rating agencies made sure that minimal disclosure was made to the risk takers (who ultimately, anyways, were represented by agents who didn't care much about extreme tail risk). And then it all blew up! A) Markets fail all by themselves and B) governments make things vastly worse when they "protect" investors by substituting rating agencies for investor responsibility. Oh yeah, and don't forget to make sure that said agencies are paid by the investment dealers!

All that looks to me like NK plus some stuff. You need liquidity constraints (see e.g. Eggertsson and Krugman 2010), but if you want the full story, you probably also need to think about information asymmetries. That's not standard NK stuff, but people certainly have looked at formation of expectations within that framework. The defining feature of the NK model (vs e.g. RBC) is that the real rate is a policy instrument, not a market determined rate. The fact that Cochrane (also Andolfatto) has come around to this is pretty big, since accepting liquidity traps is a necessary consequence.

Anyways, Cochrane acknowledges that the natural rate could have been extremely low in 08/09, but he questions why it's still the case. I don't think that's very complicated either. Consumers are still way less wealthy than they thought they were. The economy *could* speed up if owners of capital would pick up the slack and spend where consumers won't. But the economy can't suddenly shift from making a consumer oriented basket to a luxury/capital good basket. As long as we keep producing the old basket, demand will *appear* deficient. Effectively our wealth distribution problem *becomes* a structural problem. Could you model that in NK? Probably. You'd need two goods (general and luxury), time for retraining workers from producing one good to the other, and two agents with wealth dependent liquidity constraints and goods preferences. Add a wealth shock. Seems feasible though not necessarily analytically tractable. But that's why we have computers.

Basically we have a choice: either redistribute wealth and watch the economy take off, or enforce the existing distribution (and debt contracts) and wait for the adjustments in output to occur. Shows you how non-neutral wealth transfers can be once you permit liquidity constraints, information asymmetry and incomplete markets.

What is permanent about a financial crisis? Well, our memory of it for one thing! There has to be a place in economic models for learning, right? It can't be all forward-looking, rational expectations, the past doesn't matter, etc.

Could it be that "economics" has made a very simple subject needlessly into a very complex one, one that is not true (i.e., in the same way that physics created string theory). Aren't people going to look back at this era and lump the two together as "academic frauds on a system wide scale." The two have the all the characteristics: meaningless math,no experiments, no ability to forecast, and no connection to reality in their models.

Keynes wrote a more than adequate description of depressions. His argument that countries with a current account surplus had to switch to a short term deficit was right on the mark. We have just spent 6 years proving him right.

Isn't time to admit that life is a confidence game (which it is, for there is no law of the universe---or economics---that says that either a bushel of corn or a bar of gold has any set value) and that Chuck Prince was right when he said, "As long as the music is playing, you’ve got to get up and dance."

"All we need is music, sweet sweet music."

With that view, our mistakes are in not making all loans non-recourse and in failing to make bankruptcy a revolving turnstile, of no moment or consequence.

And, the manual and definite book for this era has already been written, Confidence Men: Wall Street, Washington and the Education of a President by Ron Suskind

Ok, a little off subject here. (I'm not enough of a macro guy to have an intelligent comment on the models and whatnot). So I'm just going to rank on you for one of my pet peeves. Namely, that people consistently treat The Economist like it is some sort of holy reference whilst it has demonstrated a gazillion times that it should be ground up and used for toilet paper. (Ok, ok, their straight news stuff is worth reading but their "analysis" is way too often dog doo.)

Why did you choose to put up the Korea and Sweden graphs from Mark Thoma's post. If you read his whole post you find out that these two graphs come from a 2012 article in The Economist and are like something straight out of "How to Lie with Statistics". (They cut off at different years and leave off a whole bunch of data.) As Mark's graphs show including the rest of the data shows a whole different story. Korea has languished while Sweden has been a relative success. Thus demonstrating the horrors of nationalizing the banks! Not.

You could have picked Korea and Finland or Norway (ok, Norway's drop is way less dramatic and Finland looks to be slowly but surely getting back on the good foot). Or you could have picked another Asian country like Indonesia or Hong Kong.

Anyways, my point is that I'm sick of The Economist being treated with so much respect seemingly on name recognition alone. I personally eye people with suspicion if I see a big pile of that magazine in their office.

Completely off topic, I just discovered Krugman kind of beat you and Matt to Phlogistonomics by more than a decade!

"A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle—a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire."

This new paper by Dominguez and Shapiro: http://papers.nber.org/papers/w18751#fromrss argues for the negative shock hypothesis. I still think it's an important question of why this recovery was so fragile.

Call me crazy, but I see nothing puzzling in the drop of consumption. From 1960 until the early 1980s, the personal saving rate was about 8% of GDP. Consumption, as a share of GDP was about 64%. From the early 1980s until before the crisis the personal saving rate gradually fell to about 2%, and consumption rose to about 70% of GDP. Even today, the personal saving rate, which stands at 6.5% is still lower than it was in its pre-1980s days. So maybe the drop in consumption is a return to normalcy, and the real puzzle is why it was so high for about 25 years (1983-2008).

Sure we can, but then we would have to go beyond NK models. - Frictions in the reallocation of labor from consumption sectors to other sectors (so-called mismatch)? - Uncertainty about which sectors to invest in?- Policy uncertainty (e.g. the continuous debt-ceiling debates)?The list goes on!

Yep, and I can think of lots more. NK models are popular but I think they're probably a bust. They seem to me like exercises in curve-fitting with no out-of-sample predictive power (i.e. overfitting). And they're so opaque and stylized that it's very difficult even to tell what they include or don't include, because the abstract stylized things in the models could be (and commonly are) interpreted to represent a lot of different stuff.

To me the one selling point of NK models is that they fit curves better than RBC models. That's not nothing but it's not much...

Just speaking personally and hence anecdotally, my wife and I have a hugely different attitude toward debt now. Every time I use my credit card, I feel like I am playing Russian roulette. I hate the damn things, but given that our monthly income only slightly exceeds our routine expenses - which currently include a mortgage and much of my son's college education, it is unavoidable that we have to use them. The biggest psychological factors behind our changed attitudes and emotions seem to be: (i) lack of confidence about job security and income security, (ii) the perception of a decline in real income, (iii) a general feeling of doom about the future. In the past, there was just this sense that you kept rolling over the personal debt because the future would always be better, and income would gradually rise to keep pace. But no more. Expenditures that we use to make pretty regularly in the past now strike us as terrible extravagances.

From the standpoint of the the company I work for, my sense is that there is a general reluctance to invest to expand because nobody knows where the customers are going to come from, since we perceive the customer base to be poorer and more unemployed than they used to be. There is still investment, but the strategic purpose of the investment seems to be (i) to avoid losing further ground and (ii) to win the struggle for market share in a zero-sum or declining environment.

On the issue of how diverse are government responses, I was doing some reading recently about the post-2008 policy response in the developed world, and listening to some podcasts from the LSE, and I got the strong impression that there is a more-or-less coordinated and uniform global policy response. The IMF, the large investment banks and a few other such organizations write the playbooks, and the politicians execute them. There is a uniform pattern of austerity, government downsizing and restructuring, and budget-obsessed policy planning going on everywhere.

I also meant to add that if the question is not about consumption, but business investment, it strikes me that we are in a situation where businesses are in a low-employment Nash equilibrium. An individual business would invest more if it new that all of those other businesses would invest more, because if they all did this the first business would have more employed customers with higher incomes, and their investment would pay off. But given that an individual business cannot influence of other businesses, their best strategy is to stand pat. This sub-optimal equilibrium cannot be dislodged on the central bank and financing side, because financing costs are already magnificently low, and despite the fantasies of some economists, there is no mechanism by which a central bank creates "easy money" that does not operate through the financial system.

It seems to me that the best approach is for the biggest customer in the universe, the US government, to walk into the bazaar, throw its giant money sack down on the ground, and say "I'm here to buy stuff!"

Hm... Cochrane thinks the explanation is that people knew that government would adopt the kinds of policies that he personally opposes, and thus stopped consuming. Seems a little convenient.

But I don't get the quick dismissal of this: "Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy."

Why is it valuing the future instead of the present? It's fearing the inability to consume at "subsistence" levels in the future and thus living closer to it now.

I don't see what's at all far-fetched about that, in part because that's exactly what I've personally done. I've reduced leverage, saved more cash and put off significant purchases. I've recently relaxed it a bit, but its been standard operating procedure (driven primarily by personal professional developments) for several years.

I know things are getting tougherWhen you cant get the top off the bottom of the barrelWide open road of my future now...Its looking fucking narrowAll I know is that I don't knowAll I know is that I don't know nothingAll I know is that I don't knowAll I know is that I don't know nothing....And that's fine

I am not going to pretend that I understand every argument that Cochrane is making, something sorely sticks out.

I don't believe consumption is highly dependent on interest rates or Fed policies that "manipulate" future exceptions of the populace. It is more dependent on income.

Most people are ignorant of the Fed and lack basic financial management skills. The era of debt living via high credit card rates is the new norm, therefore I doubt animal spirits will become unleashed with lower interest rates or expected lower interest rates.

Even if the Fed can persuade people that it will hold interest rates low for a long time, this is irrelevant if banks are unwilling to lend.

Plus, 99% of the populace does not take into consideration expected inflation rates when making consumption purchases. It amuses to a great extent that economist believe the most Americans take into consideration the Fisher equation when making purchases.

Seriously, a significant amount of Americans didn't even realize Obama cut payroll taxes, yet economist believe that they take into consideration the Fisher equation when making decisions?

I understand the inverse relationship between interest rates and C, I, and Nx. However, I don't believe that consumption is highly dependent on interest rates. It is more dependent on income.

While income is dependent on capital, it is not evenly distributed. Capital's share of income is highly evenly and a cause of widening income inequality.http://www.clevelandfed.org/research/commentary/2012/2012-13.cfm

Plus, incomes used to rise in tangent with labor productivity. While increases in capital make worker's more productive, the link between labor productivity and income has broken down over the past few decades. http://www.bls.gov/opub/mlr/2011/01/art3full.pdf

Why isn't the depressed economy simply a result of most consumer's major asset (their house) suddenly losing most of its equity and therefore suddenly everybody is feeling poorer? Consumption will have to reduce because now the consumers feel like they have no back-stop to their buying power, i.e. they can't take equity out of their house if needed. How would this have been turned around quicker than it was? How would everybody's mortgage principal have been reduced? How would their house price have been increased? This is very simple and not complicated at all - there was a housing boom which temporarily compensated for the stagnant wages of the middle class and now there is nothing to take its place.

No, that won't do. The US is actually less "depressed" than other economies such as the UK that have not suffered such a major housing market correction. I really wish it were that simple, but I don't see how it can be. I think those who talk about a pandemic of pessimism and hair-shirt-wearing are on the right lines.

What? The US had "some" stimulus in 2009 and the Cameron government instigated massive cuts. Are we supposed to take into account government policy too? I thought the exercise was - why has the recovery been weak all across the globe? In some countries the economy is weaker than others but why isn't that just differences in their economies and policy responses by different governments.

"Consumers realized in fall 2008, that this recession was going to last forever rather than bounce back quickly, and they adjusted consumption downward accordingly. They were right. Just how they knew, when all the Government's forecasters thought we would quickly bounce back, is an interesting question."

The only prediction humans reliably act upon is the prediction that the future will be just like current conditions. This behavior applies to groups as well (see "Reform, financial" and "Control, gun").

It seems like a terrible cognitive bias to have, but Tit-for-Tat has always done pretty well in IPD competitions ;).

"Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy... "

Why is this hard to believe?

There has been a massive fall in the net asset position of most households, and a large short term increase in their probability of experiencing a spell of unemployment. If they think about the future, the risk that they will need more savings than they have, has increased greatly. If you think about this from the point of view of the median person this is obvious.

But yes, there is something missing from this analysis. The long term imbalance in trade and how this led to false views about the value of assets. It is the overvalued dollar that mainly responsible for most of the fall in the natural rate of interest (domestic investment is less profitable than it was, and the inflow of capital to offset the trade deficit has pushed down returns). I suspect leverage (increasing the amount of financial capital available for investment) has also played a part, but I don't have a model for this.

I realise of course having written this that Cochrane thinks the natural rate of interest (which I see as the full employment rate of interest) is the same thing as the consumer rate of discount (i.e. it doesn't depend on the marginal return to investment). I think this is rubbish, but maybe Noah might want to address this.

By the way I don't really even to pretend to understand what an aggegate consumer rate of discount means (given that each individual has an individual rate of discount). How do you meaningfully aggegate them?

The Euler equation in continuous-time models predicts that, in the long run, the real interest rate should equal the personal discount rate. If it doesn't then people will re-arrange their consumption time-path. They will consuming more now (save less) and less later if the interest rate on saving is not high enough to compensate their impatience, thereby causing the interest rate to rise, or less now and more later if the opposite is true. So Cochrane is not saying anything out of mainstream here.

"in the long run, the real interest rate should equal the personal discount rate." - whose - and aren't you assuming it is constant? And what about the rate of growth of income - doesn't that have an influence too? If I consume more now then the rate of investment falls so my income falls in the future. And then depends on the expected return to investment not my discount rate.Aggegating spending is easy. Aggegating a personal discount rate - um????

By the way the throw away line about "full employment rate of interest is an ill-defined concept" is just that - a throw away line. The definition is in the name - and it is not a difficult concept to understand -the rate of interest at which ex-ante savings and investment plans match at a NAIRU level of income.

How you measure it is another problem. But how do you measure the aggregate pure personal discount rate?

As for the previous issue - it is easier to see if you think of the negative case - where income is expected to fall. Then people regardless of their preference to consume now or consume in the future, will accept even a negative rate of return on savings to ensure that they can eat tomorrow. That is because of diminishing marginal utility of consumption. You can sort of argue around this by saying that income expectations are included in the personal discount rate (i.e. you are comparing the marginal dollar with a marginal dollar at a lower income tomorrow) - but then it becomes endogenous and ceases to be an explaining factor. Partial analysis (ceterus parabus) may be fun, but it is often totally misleading.

Sorry for the multiple posts - but I hope CA will reply a little less glibly.

Let us think about what the real natural interest rates equalling the personal discount rate tells us NOW, when we have a liquidity trap (i.e. the real natural interest rate is negative). It says that NOW people are much less "greedy" than they were in the 50s when they were saving much more. Huh?

a) The full employment rate of interest is an ill-defined concept because your definition is ill-defined! What constitutes full employment? 0% unemployment? 1% unemployment? What? And according to what criteria? Moreover, you assume that the government (e.g. the Fed) can determine the real rate of interest not only in the short run but also in the long run. Theory says that it cannot. If you believe that it can, you need to specify how and where theory is wrong.

b) I am not sure I understand your first post. The concept is quite clear. Most people prefer to consume now rather than later. This is what the discount rate is about, impatience. However, consuming more now is costly because, by collecting interest, by sacrificing a unit of consumption today you can earn more than a unit in the future. If people's impatience is greater than the reward from saving (the interest rate), people will move consumption from the future to the present by saving less now. The decrease in saving will drive the interest rate up until the two are equal. If the opposite is true then people will increase current saving, driving the interest rate down. This is a simple, intuitive result. Now, you can add income growth, heterogeneous preferences, risk aversion (preference for smoothed consumption), etc. Does any of this change the basic idea? No! It is just a smoke-screen.

c) Your explanation in your second post shows confusion. Cochrane talked about the long run. It is hard to justify the existence of a negative long-run rate, particularly if income is expected to grow as it has been doing since the industrial revolution due to technological progress. Your analysis pertains to the interest rate response during a recession, when GDP deviates from its long run trend. Regardless of whether what you wrote is correct, it is therefore clearly not a response to what Cochrane was saying. Unless, of course, you are willing to argue that people view the current drop in income not as a temporary phenomenon, but rather as part of a long-run negative trend that defies the experience of the last few centuries.

In conclusion, I understand that you don't like Cochrane. That's fine. All I ask is that you please take him on when he says things that are obviously rubbish and not on every technical issue he happens to mention, particularly when he happens to be correct.

I understand perfectly that the demand for savings is an upward sloping function of interest rates, which is all your argument says. But markets have two sides. And the THEORY (and it is just a theory) about long run interest rates being DETERMINED SOLELY by preference for consumption today as against tomorrow looks decided wonky empirically. That Cochrane treats it as a fact says a lot about him.

I think in this case we are being tripped up by terminology. I guess every individual, at any point of time has a decision about how much to save and how much to consume that is an increasing function of the interest rate. In other words it will be an equilibrium condition that FOR EVERY INDIVIDUAL the discount rate AT THAT RATE OF SAVINGS is equal to the interest rates. But this discount rate must change as savings changes - or else the individual will chose to save more or less. So the problem with quoting this as being something meaningful, is that it is turning causation on its head. It is the return on capital that determines how much incentive can be given to save. This "consumer's discount rate" is not some exogenous single rate. It is a point on a curve, the reading of which depends on interaction with other factors.

So saying "Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy..." seems to me very confused! It assumes there can be an instantaneous adjustment - that an increase in desired savings translates immediately to an increase in actual savings.

it is not demand for saved funds (for investment purposes) that is an increasing function of the interest rate, but supply. Demand is decreasing, because of diminishing marginal returns to capital. The discount factor is NOT a point on a curve, this is what you do not understand. It is a stable preference parameter that determines the long-run interest rate. In other words, the long-run supply of saving is perfectly elastic at the discount rate even if the short-run supply is upward sloping.

For example, suppose that saving rises. The ensuing decrease in interest rates should stimulate investment, which will cause a drop in the marginal product of capital. But the drop in the marginal product of capital should eventually restore consumption to its previous level, since people will not receive a reward big enough to compensate them for sacrificing current consumption for future consumption. Unless, of course, there has been an increase in people's patience (lower discount rate) so that people are willing to accept a lower interest rate (lower marginal product of capital) to save the same amount of funds as before. Cochrane is not saying, "that an increase in desired savings translates immediately to an increase in actual savings." He is saying that he does not buy that there has been such an outbreak of thrift, that people all of a sudden have become so much more patient. Of course, there can be other, structural reasons why people's saving behavior has changed. But New Keynesian models do not explicitly model these reasons, and instead try to capture such phenomena by modelling them as changes in people's patience. This is what Cochrane has a trouble with.

Huh? What are you replying - I never implied that investment was an increasing function of the interest rate but the savings was.

"The discount factor is NOT a point on a curve, this is what you do not understand. It is a stable preference parameter that determines the long-run interest rate. In other words, the long-run supply of saving is perfectly elastic at the discount rate even if the short-run supply is upward sloping. "

This makes zero sense to me, sorry. If I save more now I have more income in the future. If I have more income in the future then the value of consumption NOW increases relative to income in the future. There is a a clear marginal trade off. This comes from people having finite lives. That people all would all infinitely reduce consumption at a particular interest rate defies rational explaination. I'm not even sure what you mean by "long-run" in this sense. Or why you think this particular value would be shared by many people - each individual has a different tradeoff. It seems to me you are assuming that such a value exists. Where does it come from and how would you measure it?

Besides - this issue of a point or a curve is irrelevant (a red herring) - the curve or point can shift up or down. But ultimately the market is a cross and shifts up and down in the returns to capital can have the same effect.

And why argue about the long term - I thought everybody agrees this is a short term issue - so why is Cochrane hung up about it.

"In other words, the long-run supply of saving is perfectly elastic at the discount rate even if the short-run supply is upward sloping. "

do you mean (and this is the only way I think I can interpret it) - in the long-run (which long-run precisely?) there is some magical interest rate above which people completely stop consuming and below which people completely stop saving?

the lack of deflation since 2009 is a problem for some New Keynesian modelsWhy is this, and what is the standard explanation for why the Fed has been able to lower rates for the past 30 years while seeing inflation drop? What if there's a persistent deflationary pressure that is being offset by the Fed's low interest rates? My pet theory (of course I have a pet theory) is that the wealthy are acting as a money sink, removing it from the real economy at increasing rates. Globalization and, increasingly, labor-saving technology have shifted economic power to capital, who are by definition net savers, and the effect on consumption was hidden by a massive credit expansion which ended suddenly, as such things tend to do.Lars

what is the standard explanation for why the Fed has been able to lower rates for the past 30 years while seeing inflation drop? What if there's a persistent deflationary pressure that is being offset by the Fed's low interest rates?

Well, and now we run into the bigger problem of the near-impossibility of generating a counterfactual in macroeconomics...